Monday, September 6, 2010

Social Security May Plug the Payback Loophole

I’m sure this provision in Social Security started life as someone’s altruistic idea to help out folks who made a poor decision. Essentially, the payback works like this: you can restart your Social Security benefits to eliminate any early retirement reductions and take advantage of delayed retirement credits with one small hitch—you need to pay back any benefits you received with interest.

What’s wrong with that? If someone made a bad choice, why not give them a do-over? Because the only people who can take advantage of this payback option are those with enough money on hand to pay back all their previous Social Security benefits. That does not include most people.

Let’s take a simplified example that ignores the effect of cost-of-living adjustments and interest charges. Mr. Former Wage-Earner started benefits in 2005 at age 62 at the rate of say $10,000 per year. His full retirement age was 66 (in 2009). If Mr. Wage-Earner had waited until 2013 to start benefits they would have been (again ignoring COLA adjustments and Wage Base Increases) roughly $17,500.

Under the payback rules, he could stop benefits, pay back $80,000 (8 years at $10,000/yr.) and for the rest of their life get $7,500 more per year in benefits. Still ignoring interest, as long as he lives to age 81, he’s ahead of the game.

Since most retirees should be much more worried about longevity risk than the date they break even, this is an excellent deal for those in decent health since it provides 75% more benefits for folks who live to ripe old ages, mitigating the risk of living longer than money lasts. Further, if you compare this deal from Social Security to the cost of purchasing a life annuity with full CLOA from an insurance company at age 70, you’ll discover this is a also an excellent monetary deal from that standpoint.

Because people are using the payback for other than “oops” situations, the Social Security Administration wants to change the rule so it only applies for the first year after Social Security benefits start, which covers the purported original intent of the provision.

If you want to take advantage of this loophole (1) get top-notch investment advice about whether this makes sense and all of the ramifications, and (2) hurry—the loophole may not last long.

~ Jim